An Introduction to

The Economic Way of Thinking

Justin P. Isaacs

An Intersting Comparison

An Interesting Comparison
Yanamamo TribeHunter-Gatherers
$100/person annual income
300 total goods in village

Manhattan TribeConsumer-Traders
$40,000/person annual income
10 billion goods in village

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Introduction
How does the activity of billions of
individual humans generate the collective
phenomenon of culture, or society?
How does an economic system work when
it is functioning properly?
What mechanisms of social cooperation do
we depend upon?
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Recognizing Order
Rush hour traffic is an example of
social cooperation.
Thousands of diverse commuters travel to
work each day
Each is expected to follow a set of rules
Traffic flows smoothly

We tend to notice failures.

We take successes for granted so much so
that we arent even aware of them.
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The Importance of Social Cooperation

Civilization depends upon
cooperation.
Thomas Hobbes (1588-1679)
Contended that peoples commitment to
self-satisfaction required force to keep
them from attacking one another.

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How Does It Happen

How does society determine the

course of actions necessary to
produce the goods and services we
enjoy?

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How Does It Happen

Adam Smith (1723-1790)
Most people believed political rulers
attention was necessary to sustain society.
Smith disagreed.
In 1776 published An Inquiry into the
Nature and Causes of the Wealth of
Nations.
Founder of Economics
People guided as if by an Invisible Hand.
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Smith Was the First

An Economic system is a social system
humans cooperate
creating and using resources to satisfy
wants

Question: Why do some systems

accomplish more?
Is it simply that some nations start with
more resources?

A Picture of Rich v. Poor

Who Is Rich, Who Is Poor? Lets

Expand our Example
World Bank
using gross national product per capita
classifies countries
high-income economies
middle-income economies
low-income economies (<$1,000
income per resident)

How can we explain wealth and

poverty?

The Historical Record

GDP per capita (2011)
U.S. - $48.442
777 times 1820 level
India - $1,489
almost 10 times 1820 level

GDP growth in U.S . average annual

rate of better than 3% between 1820
and 2011

The Historical Record

Explaining the difference in growth
economic growth requires a surplus
that can be invested in productive
capital

Possible sources of surplus

imperialism
exploitation
saving

The Historical Record

Observations:
many of the poorest countries were
never subjected to conquest
many of the richest were never
colonized

from 19501973:
world economic growth 4.9%
per capita world growth 2.9%

The Historical Record

From 19731990:
Latin American growth slowed
Soviet Union and Africa per capita
income fell
Europes growth rate would only
double per capita income every 50
years
Asias growth rate would double per
capita income every 25 years

Sources of Economic Growth

Rule of law
Low cost systems of exchange
Specialization
Stocks of physical and human capital
Technical innovation

Foreign Investment
Foreign investment may supply the
surplus required to stimulate growth
in poor countries
Two main sources:
private investors
foreign aid

Foreign Investment
Issues with private investment
risk of nationalization
may benefit only the political leaders

Advantages of private investment

provides the expertise to utilize the
capital that is loaned
more accurately measure the
probability of success of a project

Foreign Investment
Issues in foreign aid
what is the quid pro quo of the giving
country?
how will the aid be allocated?
trade or aid?
foreign aid may prop up bad
governments

Aid has made large contributions to

development

Human Capital
Education and human capital
literacy is a precondition for economic
growth
productive knowledge and skills
makes individuals wealthy

Question: Does human capital

contribute to the growth in the wealth
of nations?

Oil Comes from Our Minds

Knowledge is the crucial factor in the
process of economic growth
Human intelligence eventually saw a
way to use oil for human purposes
Ideas matter
Know-how

Economic Freedom Index

An economic freedom index (EFI)
seeks to measure a countrys
economic openness, including

regulation
pricing practices
monetary policy
fiscal policy
international trade

Economic Freedom Index

Fact: countries that follow policies
ranking highest in EFI have the
highest levels of per capita GDP

Economic freedom index

Figure 161 Economic freedom and income

The Developmental Power

of Private Property Rights
Adam Smith in The Wealth of Nations
(1776) found that people grow
wealthier with the freedom to
participate in the market process
Data (2005) show
least free have GDP per person of
$3,300
most free have GDP per person of
$26,000

Figure 1.2 Income and

Happiness: Comparing Countries

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World Values

An Apparatus of the Mind

What is The Economic Way of Thinking?
It is a method rather than a doctrine, an
apparatus of the mind, a technique of thinking
which helps its possessor to draw correct
conclusions.
All social phenomena from the actions and
interactions of individuals who are choosing in
response to expected additional benefits and
costs to them.
Does this assume people are selfish, materialistic,
and shortsighted?
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An Apparatus of the Mind

Economics is a theory of choice and its
unintended consequences.
Focus is on actions, interactions, and
consequences.
Actions emphasize economizing.
Economizing Allocate resources in a way that allows the
economizer to derive whatever he/she wants
Results from scarcity
Involves trade-offs
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An Apparatus of the Mind

Economic theory assumes that :

People make
choices
under scarcity
based on

Expected
Benefits

and
Expected
Cost
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An Apparatus of the Mind

The core problem for economic
interactions is a multiplicity of diverse
and even incommensurable individual
projects.
Specialization (Division of Labor)
Results from peoples economizing actions.
Is necessary to increase production.

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An Apparatus of the Mind

Adam Smith referred to the Commercial
Society in his Wealth of Nations and
said
It is but a very small part of mans wants which the
produce of his own labour can supply.
He supplies the far greater part of them by
exchanging that surplus part of the produce of his
own labour, which is over and above his own
consumption, for such parts of the produce of other
mens labour as he has occasion for.
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An Apparatus of the Mind

Adam Smith and the Commercial
Society
Every man thus lives by exchanging,
or becomes in some measure a
merchant, and the society itself
grows to be what is properly a
commercial society.
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An Apparatus of the Mind

All social phenomena emerge from
Individuals actions and interactions
In response to expected benefits and
costs
How are the parties involved in
producing goods and services motivated
to coordinate their activities?

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Cooperation Through Mutual

Adjustment
Economizing actions create
alternatives available to others.
Social coordination is a process of
continuing mutual adjustment.
Why dont drivers on a freeway drive in
one lane?
The net advantage determines peoples
actions
Costs versus Benefits
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Rules of the Game

Economic systems and social
interaction are directed and
coordinated by the rules participants
know and follow.
Disputed inconsistent unclear
rules cause the game to break down.

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Property Rights as Rules of the Game

Property rights are an example of
rules of the game of social interaction.
A market exchange economy is based
upon private property rights.
Socialist economies private & public
property rights.
Change away from socialism may be
chaotic i.e. Soviet bloc.
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Frost: Mending Wall

Good fences make good neighbors.
What is the fence a metaphor of in this
poem?
Do you think fences promote
neighborliness, why?
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Property Rights as Rules of the Game

Clearly defined and enforced property
rights
Encourage the effective use of already
existing scarce resources
Spark efforts to discover new resources
Innovate new cost-cutting technologies
Develop new talents and skills

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The Biases of Economic Theory

Economics focuses on choice.
Events result from peoples choices

Only individuals choose.

Individuals choose after weighing
benefits and costs
Interactions assume some rules of the
game.

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No Theory Means Poor Theory

Discovery of causal relationships
depends upon theory.
We observe only a small fraction of
what we know.
The rest we fill in with from the various
theories that we hold

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Globalization and Its

Discontents
Critics say the Washington
consensus
creates a race to the bottom
sees the World Bank, IMF and WTO
imposing their policy preferences
(known as conditionality)

Evidence suggests the opposite of

these claims

The Power of Special Interests

The message of economists has a
hard time getting through
perhaps economists do not
communicate their policies well
enough?
or do special interests frustrate good
policy with politics?

Role of the horizon of rule

Outsourcing controversy:
soundbytes vs. analysis
Basic economic reasoning suggests
that the rich-poor gap is not the result
of voluntary trade
Global outsourcing can be viewed as
another manifestation of beneficial
trade
In the U.S. economy, while some old
jobs maybe destroyed, new ones will
be created

Once Over Lightly

Economic growth and specialization
Low costs means of exchanges will
increase specialization and economic
growth
Rule of law also essential for
economic growth
Economic growth has depended upon
the accumulation of capital